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The Field of International Trade Had Considered a Wide Array of Factors NBER WORKING PAPER SERIES INTERNATIONAL TRADE, MULTINATIONAL ACTIVITY, AND CORPORATE FINANCE C. Fritz Foley Kalina Manova Working Paper 20634 http://www.nber.org/papers/w20634 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 October 2014 Forthcoming in the Annual Review of Economics 7, doi: 10.1146/annurev-economics-080614-115453. Foley thanks the Division of Research of the Harvard Business School for financial support. Manova thanks the Stanford Center for International Development for financial support. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2014 by C. Fritz Foley and Kalina Manova. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. International Trade, Multinational Activity, and Corporate Finance C. Fritz Foley and Kalina Manova NBER Working Paper No. 20634 October 2014 JEL No. F10,F20,F23,F36,G3 ABSTRACT An emerging new literature brings unique ideas from corporate finance to the study of international trade and investment. Insights about differences in the development of financial institutions across countries, the role of financial constraints, and the use of internal capital markets are proving central in understanding international economics. The ability to access financial capital to pay fixed and variable costs affects choices firms make regarding export entry and operations, and, as a consequence, influence aggregate trade patterns. Financial frictions and the use of internal capital markets shape decisions that multinationals make regarding production locations, integration, and corporate governance. This article surveys this recent research with the goal of highlighting the main themes it explores, the key results it establishes, and the leading open questions it raises. C. Fritz Foley Graduate School of Business Administration Harvard University Soldiers Field Boston, MA 02163 and NBER [email protected] Kalina Manova Department of Economics Stanford University 579 Serra Mall Stanford, CA 94305 and NBER [email protected] 1 Introduction Until recently, the international economics literature and the corporate finance literature have evolved separately. Research on international trade has focused on the role of economies of scale and cross-country differences in productivity and factor endowments in predicting gains from trade and the pattern of aggregate trade flows according to comparative advantage. Additional insights have emerged from introducing firm heterogeneity in trade participation when there are fixed and variable trade costs. Research on the activities of multinational firms has also emphasized cross-country differences in productivity and factor endowments, as well as trade costs, market size, and economies of scale as the key drivers of the decision to locate production abroad. Moral hazard and intangible assets govern when it is advantageous to offshore production within the boundaries of the firm rather than at arm's length. Much of this work on trade and FDI pays little attention to corporate finance considerations, and effectively assumes that firms can access the financial capital necessary to implement their first-best investment choices. This in part reflects the historical challenges of measuring differences in access to capital across countries and offering motivation for such differences. The corporate finance literature, on the other hand, has studied how firms obtain the funding needed to pursue attractive business opportunities when financial markets are imperfect. Managers are often assumed to know more about investment alternatives than investors, but to not always act in investors’ interest. Information asymmetries and moral hazard make it costly for managers to raise capital from outside the firm, and feature prominently in corporate finance research. This research thus provides frameworks for thinking about how and why access to capital might vary across heterogeneous firms, as well as across countries with different institutional environments. Traditionally, however, the finance literature has concentrated on companies that operate in a single country, and only some strands of this work draw attention to cross-country differences that affect firm decisions. This survey article reviews new perspectives on international trade and multinational firms that have been generated by bringing unique insights from the corporate finance literature to bear. Section 2 describes work that provided the building blocks for these advances. In the international economics literature, scholars considered how factor endowments shape trade patterns and firm choices about which activities to conduct in which locations. The introduction of heterogeneous firms that incur costs to engage in trade or foreign investment was also important because these costs must be financed. In the corporate finance literature, analyses that extended the treatment of capital market imperfections to an international setting played a valuable antecedent role. Studies established the existence of large differences in the availability of capital across countries, and showed that financial markets are not perfectly integrated across borders. Research on trade credit, or the financial arrangements between firms in buyer-supplier relationships, facilitated the understanding of financial contracts that exporters and importers use to meet their working capital 1 requirements. Findings about the allocation of capital within firms proved pivotal to the analysis of multinational corporations’ financing practices. Section 3 summarizes the literature that incorporates corporate finance considerations into the study of international trade. It outlines the mechanisms through which financial frictions may impede trade in theory, and discusses the empirical evidence of these mechanisms at both the aggregate and firm levels. It evaluates the impact of financial conditions on international commerce relative to overall production, considering both normal economic times and crisis episodes. Lastly, the section examines the types of financial contracts that support international trade. Section 4 reviews the literature that brings corporate finance considerations into the study of foreign direct investment. It emphasizes how multinationals may use internal capital markets to pay for fixed costs, address managerial moral hazard, and exploit differences in access to capital across countries. As a result, financial frictions shape multinational decisions regarding production location, integration and corporate governance. This section also addresses how financial factors affect the spillovers that multinational companies have on local firms. Finally, Section 5 concludes and highlights policy-relevant open questions that might provide fruitful avenues for further advances in this research agenda. 2 Antecedents 2.1 International Trade and Investment Historically, the international trade and investment literature has taken cross-country differences in capital availability into account, thereby raising the possibility that such differences might affect patterns in trade and multinational activity. However, this literature often makes specific assumptions of what capital is and how its accessibility might vary globally that can be enriched by taking a corporate finance perspective. International economics frameworks that emphasize endowments of input factors often consider the role of physical capital, as opposed to financial capital. For example, in trade theories that adopt the Heckscher-Ohlin-Vanek notion of comparative advantage, capital endowments are assumed to differ across countries for exogenous reasons. Capital is typically not internationally mobile, and may or may not move freely across sectors within an economy. As a consequence, returns to capital can vary across borders. While analyses in this vein open questions about the potential tradability of physical capital and the role of financial capital, they do deliver the prediction that capital-abundant countries should export relatively more in industries intensive in that input factor. Similarly, in theoretical models of firms’ motives for engaging in foreign investment, capital availability could play a role, but this possibility has traditionally not been examined in detail or through the lens of corporate finance. Consider, for example, research that studies how cross-country differences induce 2 firms to locate different activities in different places. In a seminal paper, Helpman (1984) develops a two- country, two-sector Heckscher-Olin model in which firms decide where to undertake manufacturing. Labor and a general-purpose input are used to produce differentiated goods. Multinational companies arise as a result of the exogenous variation in the two factor endowments across countries which generate different factor costs. Even though the second input is not labeled physical capital, it shares some characteristics with physical capital in that it is combined with labor in production, and in that sense access to capital may influence the locational choices of multinationals. The related empirical literature
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